Pigovian Analysis 

The starting point of the Pigovian welfare analysis is the notion that there  is a resource allocation  problem  that can be  optimally  solved. Through  his work, Pigou made clear that society was  faced with the  choice of how  to allocate scarce productive resources  to  competing ends  and  was to  maximise total social welfare.  In  practical terms, this reduced  to  maximising economic welfare, "that part of total welfare which can be brought directly or indirectly into relation with a money measure". 

Pigou was concerned about the channeling of "real"  factors of production  to their best  uses. He saw particular configurations  of  factors  of production  as yielding  a  measurable worth  of  total  output  and sought  that  arrangement generating a maximum value. After setting the main problem  of inquiry as 'the allocation of real  factors of production  to  maximise  the  total value  of  output', Pigou tried  to  describe some characteristics  iadicative  of  an  optimal configuration and define deviations  from  this  optimal solution  as  inefficient.  A  crucial  part  of  the analysis was the concept of changes in output resulting from a movement of resources from one use  to another. Pigou defined marginal netproduct as 'the ' difference between the aggregate flow of product for which flow of resources, when appropriately organised,  is  responsible and the aggregate  flow  of product  for which  a  flow  of  resources differing from that flow  by  a  small  (marginal) increment, when appropriately organised, would be responsible'. 

Pigou  then  drew  a  distinction between  social  and  private  marginal  net product. The marginal social net product  is the  'total net product of physical things or objective services due to the marginal increment of resources in any given use or  place, no matter to whom any  part of this  product may accrue'. It might happen,  for  example, that  costs are  thrown  upon  people  not  directly concerned, through, say, uncompensated damage done  to  surrounding woods by  sparks  from railway  engines. All  such effects must  be  included-some of them positive, others negative elements in  reckoning up the social net product of the marginal increment of any volume of resources turned into any use or place. The marginal private net product  is that  'part  of the total net product of physical  things  or  objective  sewices  due  to the  marginal  increment  of resources in any given  use  or place  which accrues  in the first instance  i.e., Approach prior  to sale to the person  responsible for investing resources there'. In  some conditions this is equal to,  in  some it  is greater than, in others it  is less than the marginal social net product.  ' In  a  first pass through the problem, assuming no costs of resource movement, Pigou noted that  a  necessary condition  for a maximum  is  that the marginal social net product  (MSNP) of each resource employed  in  any use or place be exactly equal. Were resources  to  be  distributed so that  the MSNP  of each factor of production was unequal, the total value of output could be increased by moving resources from uses with  lower MSNP to those with higher MSNP. This  straightforward application of  the  equinlarginal principle  is  the  key  to Pigou's analysis. 

The natural extension  to the  notion of  an  ideal, global optimum  is consideration  of  impediments  that  block  the  realisation of the  best  possible result. Starting  from  a decentralised system  in which self-interested resource owners make decisions concerning the employment of their labor and capital, Pigou  presented  a  framework  that  paired  "obstacles to  free movement"  and divergence of private  from  social marginal net product  as two fundamental I elements  that prevent resources from flowing to their best uses. 

Obstacles to  free  movement  are composed of  'costs  of  movement  and imperfect knowledge'.  For Pigou,  costs  of movement  include 'not  only  the payments to the agents who transport factors of production from one place to another  ("promoters,  financing syndicates, investment trusts, solicitors, i bankers  and others",  but  also the  imperfect divisibility of productive i  resources'.  De Serpa points out that Pigou's costs of movement can be broadly interpreted  to  include  'transactions costs'  of every type (principal-agent, holdout and similar problems).  In other words,  it would seem more correct, to consider Pigou's overarching category,  "obstacles  to  free  movernent,"  which encompasses  both  costs  of movement and imperfect knowledge,  as  the appropriate counterpart to today's "transactions costs." When the assumption of no costs of movement  is relaxed, Pigou modifies the optimal solution to  be  one  in  which the MSNP of each resource diverges  by less than the cost  of movement. Obviously,  if  the  gain from driving  two MSNPs  to  equality  is outweighed  by  the cost of the movement, then such a move  is  inefficient. Thus,  in  the  presence of  costs  of movement,  a  given configuration might  show  some inequalities  in  MSNP yet  may be  the  best arrangement, not  indeed  absolutely,  since  if there were  no  costs,  a  better arrangement would  be  possible, but relatively  to the  fact  of  the initial distribution and the existing costs of movement. 

Pigou also discussed second order conditions and  considered the implications of several  local maxima. He offered the possibility that State action might be "justfled" if it  could  'yerk the industrial system out of its present poise at  a position  of  relative  maximum,  and  induce  it  to settle  down  again at  the position  of absolute maximum-the highest  hill-top of all. Later, however,  he adds  that worries  about  relative versus global maxima are  a  "secondary matter"  (see Hla Myint,  "Theories of  Welfare Economics",  Harvard University Press, 1948, p. 128). 

After discussing  how  imperfect knowledge can, like  costs of  movement, prevent  the attainment of an optimal resource allocation, Pigou  turned  to  the welfare Economics  issue of divergence between private and  social marginal  net  products.  It is important  to  note  that  Pigou  sees obstacles to movement and  divergence of private and social net product as separate, but  possibly concurrently operating factors, either of which may be manipulated by  the State in order to effect an improved allocation of resources. 

For Pigou, the problem facing society is one of allocating resources so that the total  value of output is maximised. He makes  extensive use  of the "$owing resources"  metaphor: A  flowing  stream  of  resources  is  continually coming into being and  struggling, so far as unavoidable costs of movement allow of this,  to distribute itself away from  points of  relatively  low  returns towards points  of  relatively  high  returns. A  clear  signal  of  the  performance of  any observed configuration of resources is the marginal social net  product of each resource. There  is  an answer  to  society's resource allocation  problem  and, thus, deviation  from optimality cannot only be judged  inadequate,  it  can  be improved.